What traders need to know about the looming Italian crisis

10:50, July 07th 2016

Markets are getting worried about Italian politics and its banking system. While it’s by no means certain, there’s a possibility that this situation could develop into a major market risk event over coming months. Here is some back ground information to help traders keep on top of what’s going on.

Markets are getting worried about Italian politics and its banking system. While it’s by no means certain, there’s a possibility that this situation could develop into a major market risk event over coming months. Here is some back ground information to help traders keep on top of what’s going on.

Economy

Italy is the 3rd largest economy in Europe and one of its economic trouble spots

As the chart below shows, its economy has not grown over the past 10 years. In this period real GDP growth has averaged -0.4%pa (see chart above)

Unemployment has improved a little but remains high at 11.4%

Italy’s public debt to GDP ratio is also relatively high. At the end of last year it stood at 133%

One of the core difficulties is that the economy is uncompetitive. Italy’s labour costs have continued on their merry way, becoming steadily less competitive since the GFC. This compares to some other countries like Ireland which have dramatically improved their efficiency and competiveness over this period

Traditionally, Italy’s completive position has been dealt with by currency devaluation. This is no longer possible now that its currency is the Euro.

This situation has been described as an unworkable combination of Italian management practices and a German currency. As things currently stand this conundrum will need to be resolved via introducing efficiencies and economic reform.

Referendum

Italy is scheduled to hold a referendum in October although no date has been set

The proposal is to transform its Senate into a Senate of regions. This would be composed of 100 Senators, most of whom would be regional councillors and mayors

At the moment the 2 houses both serve 5 year terms. Representatives from both houses are drawn from the same electorates. All legislation must be passed by both houses.

Recently the right wing, Euro sceptic, Five Star movement has refused to form alliances making it very hard to get anything legislated.

It is thought the reform will allow governments to be more stable and so better able to pursue much needed economic reform

The referendum will be opposed by the Five Star party. The reforms may reduce their influence and be seen as a step towards enforcing Euro inspired laws and reforms

If the referendum fails; the government is likely to fall; creating another political crisis. Many think it may be difficult to form any new government if this happens

Banks

Unlike the US and UK, Europe has been slow to reform its banking system after the GFC

The deteriorating Italian economy has meant its banks have not been able to grow out of their problems

Italy’s banks now urgently need capital.

However, because there too much bad debt has been left on bank balance sheets, Italian banks are going to find it hard to raise capital

The Government recently tried to strong arm the better banks in to creating a “bad bank” “Atlante Fund” to take bad debt away from poorly performing banks. This raised only €4.25bn compared to an estimated €360bn of bad bank non-performing loans (18% of all loans)

One of the banks most under threat is Monte dei Paschi di Siena. It’s the oldest bank in the world but has a bad loan book of around €47bn. The ECB has insisted it must reduce this by €8bh by end 2017 and a further €6bn by end 2018.

The Italian government is now trying to use the Brexit; Euro sceptic momentum to pressure the EU into breaking its rules and allowing Italy to use public funds to recapitalise the banks. It wants to put €40bn of public funds into the banking system.

Germany recently reiterated that it will not allow this

With the possibility of an Italian banking crisis looming, this situation is setting up for a Grexit style battle between Italy and Germany as Europe once again resorts to crisis mode to resolve its problems

Chart - Unicredit SPA

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Unicredit is the biggest bank in Italy. As the long term monthly chart below shows its share price is a sorry story. This month it is beginning to break below its GFC lows. If Italy does become a key focus for markets in coming months, this chart might provide some useful insight into how markets are viewing risk